With Inflation Rates At Historic Highs, Is The Stock Market Rally Still On Hold?

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The past two months have seen US and European stocks record a steady recovery, thus repairing some of the damage caused by the bear market. However, some top asset managers and market experts are not yet convinced if the rally will be sustained in the long run.

For example, the S&P 500 index, which serves as Wall Street’s benchmark, was up 13% from its September low by the time the market closed for Thanksgiving on Thursday. On the other hand, Europe’s Stoxx 600 had performed even better. The index was up 15% within the same period. As of now, October and November are on track to be the first consecutive months of growth since 2021.

However, most investors are holding off on celebrating as inflation rates are still high. This means the Fed and other monetary institutions are still inclined to raise rates to address the situation. Given how interest rates impact stock markets, this can only spell doom for the resurgent market.

According to Wei Li, chief investment strategist at BlackRock, “Markets are hoping that inflationary pressure will just magically disappear.” However, “It’s only a matter of time until the message [from the Federal Reserve] sinks in again and the reality of recession sinks in.”

Higher Interest Rates Impact On Markets

Higher interest rates by monetary institutions have been the reason why stock prices have suffered this year. However, a recent turnaround has provided a ray of hope. The biggest gain was recorded on November 10, when the S&P 500 jumped by 5.5%. It was inspired by a report that the US was seeing a more gradual inflation rate than what economists had expected.

Many investors are enticed by the prospect of lower inflation, which means the Fed will not have to raise rates as expected. This in turn should boost the relative value of companies’ future earnings.

And signs of this were at play last Wednesday when the S&P 500 jumped 0.6% following news that Fed officials were considering slowing interest rate increases after four 0.75%-point increases in a row. However, the cuts cannot be expected until spring next year, after they peak.

As mentioned earlier, interest rates have a strong influence on stock prices. Therefore, even the most optimistic investors cannot see the current two-month rally being sustained for long.

Speaking to the Financial Times, Dan Gerard, multi-asset strategist at State Street, claims that there is a high probability of a rally “through the next data cycle [in December], but in the new year, when people realize cuts aren’t coming soon, the reality of inflation” will kick in.

Europe’s Situation

French and German markets have shown the most resilience in Europe. Thus, they have contributed the biggest gains to the Stoxx 600. And US investors have also seen their inflation concerns eased after German producer prices dropped for the first time in two years. Even though economists still see a downturn ahead, falling prices of natural gas, which hit an all-time high back in August, have helped soften the situation.

Europe is also set to benefit from China reopening to the rest of the world in early 2023.

That said, some analysts see German companies as attractive investment options. Seema Shah, chief global strategist at Principal Asset Management, is one individual who shares this sentiment. She deems German stocks “screamingly attractive” from a valuation perspective.

Still, there are risks. China was placed back under lockdown last week as coronavirus cases reached record highs. Also, Russia has threatened to restrict gas supplies to western Europe.

Tim Drayson, head of economics at LGIM, notes that despite pricing out the “tail risk of blackouts and energy rationing,” European equities look overbought. He goes on to add that, “fundamentally, the profit picture is still really bleak.” Thus, he doesn’t expect the current rally to last.

Despite the grim outlook, some investors believe the current rally has time to run, even though they are cautious on the long-term picture.

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